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2 Income ETF Approaches: High Yield vs. Dividend Growth Rate

by ETF Base on June 21, 2010

There are two main schools of thought in dividend investing and for whatever reason, investors tend to be polarized into one camp or the other. On one hand, investors tend to be drawn to juicy dividend yields of 8% or more given that this matches the long-term return on equities over long periods of time but provides for current yield matching that, plus the prospect of capital appreciation. Typical holdings offering yields this high include MLPs (one of my personal favorites), Real Estate Investment Trusts (tons of them listed) and various types of energy trusts, financials and other entities with high cash flows or net payouts due to company structure, etc. Conversely, there’s an entirely different universe of stocks that have modest current dividend payouts, often in-line with the yield of the S&P500 as a whole or even lower, at say, 1.5% to 2.5%, yet they are rapid dividend growers in that they tend to increase their dividend payouts year after year at a rate even greater than inflation. It’s worth considering the pros and cons to each approach and whether perhaps it makes sense to accumulate both types of holdings simultaneously. Fortunately for retail investors, now there are ETFs to capitalize on each strategy:

High Yield ETFs

Many investors find the prospect of an 8-10% dividend yield in a near zero interest rate environment to be incredibly appealing. As long as those yields remain steady, until interest rates increase, this is indeed a good proposition. Investors should be cautioned though, that once interest rates start to increase (which they will inevitably, but many experts now expect no action on the part of the Fed until late 2011 or even 2012), that makes income investments appear to be less attractive and they may very well sell off. For individual issues, one must consider just why the yield is so high and how likely it is to last. However, there is a diverse mix of high yield ETFs from which to pick for diversification.

For the ultimate in current yield, there are the junk bond ETFs (full review) with tickers (JNK) and (HYG) showing trailing yields of 12% and 9.6% respectively. Note that these have the benefit of monthly payouts but also, these yields may not be this high in the future, as JNK’s latest payout was lower than in previous months. Then there’s always the hybrid stock-bond approach with Preferred Stocks. The Preferred ETF (PFF) yields over 7% and has already accounted for the recent demise of the Financial sector and what financial reform has to offer.

Dividend Growth ETFs

Many of the highest quality blue chips (including the only remaining 4 AAA Companies in the S&P500) have seemingly low dividend payouts but those payouts are viewed as sacrosanct and growing. Many dividend investors place more emphasis on the GROWTH RATE of dividend payouts over CURRENT YIELD. The reasoning here is that if a stock is yielding 10%, it’s for a reason – the market is pricing in a dividend cut, or it will be unlikely to pay out at that rate indefinitely. However, a company that routinely increases dividends may not show a high yield because the underlying share price keeps increasing over time in lockstep with those increased dividend announcements.

For some opportunities in this space, consider Vanguard’s Dividend Appreciation ETF (VIG) at 2.1% or the S&P High Yield Dividend Aristocrats index ETF (SDY) at 3.84%.

Which approach you focus on is dependent on many factors and perhaps a dual-approach works. Bear in mind that in trying to match up recent performance, it’s difficult to put this into context given the complete meltdown in Financials which had historically comprised a mix of both high yielders and dividend increasers.

Disclosure: Author holds HYG in self-directed IRA account. No other holdings mentioned in this article.